Question

suppose your company needs $26 million to build a new assembly line. your target debt-equity ratio is .45. the flotation cost for new equity is 9.9 percent, but the floatation cost for debt is only 4.3 percent. what is the true cost of building the new assembly line after taking flotation costs into account?

Answer 1

The true cost of building the new assembly line after taking flotation costs into account is 7.55%.

Step-by-step explanation:

The true cost of building the new assembly line after taking flotation costs into account can be calculated by considering the cost of debt and equity. The target debt-equity ratio is 0.45, which means that for every $1 of equity, there will be $0.45 of debt.

Using this ratio, the cost of equity can be calculated as follows:

Equity Ratio = 1/(1 + Debt-equity ratio) = 1/(1 + 0.45) = 0.6897

Cost of Equity = Flotation cost for new equity / (1-Flotation cost for new equity) = 0.099 / (1-0.099) = 0.1095 or 10.95%

Similarly, the cost of debt can be calculated as:

Debt Ratio = Debt-equity ratio / (1+Debt-equity ratio) = 0.45 / (1+0.45) = 0.3103

Cost of Debt = Flotation cost for debt / (1-Flotation cost for debt) = 0.043 / (1-0.043) = 0.0448 or 4.48%

The true cost of building the new assembly line can be calculated as:

True Cost = Cost of Equity × Equity Ratio + Cost of Debt × Debt Ratio

= 0.1095 × 0.6897 + 0.0448 × 0.3103

= 0.0755 or 7.55%